September 11, 2010

How do you explain Agile (or radical management) to a CFO?

Vikas Hazrati reports in InfoQ on an important conversation going
on in the Scrum discussion group about how to explain Agile or Scrum (which are
IT subsets of radical management) to a Chief Financial Officer.

In the conversation, John Goodsen offers a critical insight:

“I
like to feel them out if they understand the difference between cost and
throughput accounting, first, and then understand which model they are using.
If it's the latter, you are on solid ground. If it's the former, then you have
more work ahead of you.”

“More work ahead of you” is an understatement.

To paraphrase Karl Kraus: cost accounting is a disease of
which it purports to be the cure.

The philosophy of cost accounting

Cost-accounting is built on the philosophy of scalable
efficiency and squeezing out costs, particularly labor costs. Cost-accounting
is how you measure progress or lack thereof in an organization. Cost-accounting
is not a choice. It is legally required. Outside or external parties to a
business depend on accounting reports prepared by financial (public)
accountants who apply Generally Accepted Accounting Principles(GAAP) issued by
the Financial Accounting Standards Board (FASB) and enforced by the U.S.
Securities and Exchange Commission (SEC) and other local and international
regulatory agencies and bodies.

As a result, guess what? You find organizations focused on cutting
costs, often through downsizing and outsourcing, and suffering from crippled
innovation, frustrated customers and dispirited employees.

Even though individual CEOs and managers may fight the pressures
of cost accounting and launch imaginative initiatives to encourage innovation,
energize staff and go the extra mile for the customer, the irresistible
undertow of cost-accounting and the philosophy of cost cutting is a huge handicap and creates the continuing risk that a cost-accountant will get involved and close things down.

Similarly, Wall Street receives financial
statements based on cost-accounting and its implicit philosophy of enhancing
profits by cutting costs. As a result, Wall Street cannot see what is going on in
terms of the firms adding genuine value to their customers.

The challenge is how to get a traditionally minded cost
accountant to start thinking beyond cost reduction and focus on the velocity of
generating new value to customers and clients.

Throughput Accounting

Making decisions based on a cost-accounting mindset would be
like making decisions in a football game based on numbers of yards gained by
the opposition rather than focusing who wins the game. It would result in a one-dimensional
defensive mindset in which scoring points and winning the game become
irrelevant. It would annoy the fans, frustrate the players, and ultimately
create a losing team.

Many accountants and financial analysts agree that
cost-accounting mindset is problematic and accept the need for a way of keeping
score that reflects the true goals of an organization. But in a conservative
slow-moving profession like accounting, it has proven difficult to reach
agreement on an alternative accounting scheme.

One such system was developed by Eliyahu Goldratt for
managing factories, known as Throughput Accounting. It can be viewed as
business intelligence for enabling an organization to achieve whatever it is
trying to achieve. Conceptually throughput accounting seeks to increase the
velocity at which products and services move through an organization by eliminating
bottlenecks within the organization.

Throughput Accounting isn’t perfect, but it’s a huge
improvement on cost accounting. It can be used by a firm for its internal
accounting to improve its management, even though for external reporting, it
has to follow Generally Accepted Accounting Principles (GAAP), i.e. traditional
cost accounting.

If your CFO understands the thinking behind Throughput Accounting,
you are well on your way to having a sensible discussion about the value of Agile
and radical management. The CFO already understands the importance of
thinking through what adds value to the firm, rather than merely “how can I cut
costs?” often without examining the impact on overall profitability and sustainability.

Explaining Agile (radical management) to a cost accountant

If you are dealing with a CFO who thinks in terms of cost
accounting, then Goodsen suggests focusing more on risk than on the potential upside, because even cost accountants can understand risk:

The
follow-on conversation is about the cost of Work In Process (WIP), the cost of
Delay and the value of Limiting WIP to establish flow. You might draw an Rate of
Return on Investment (ROI) over Time chart that compares to traditional
development showing short, frequent releases do not require as deep of an
initial captial investment before you see a return.

Goodsen offers a dramatic picture of the difference between
Agile and traditional management. In Agile (and radical management) the focus
is on working in short cycles, and providing value to clients at the end of
each cycle. This is in contrast to traditional management (in software,
sometimes called “waterfall”) where work typically proceeds according to an
elaborate plan. Steadily mounting costs are incurred, in the expectation when
all the pieces come together, the investment will pay off. However even a hide-bound cost accountant is
likely to see the risks in spending more and more with no interim return. And
unless the environment is totally static, and the work totally predictable, the
impact of a delay or a technical glitch occurring. With so much invested
without any return, any delay is disastrous.

Trond
Wingård offered the numerical implications in a fictional project. In the
project, if all goes well, the waterfall mode and the Agile mode will each have
a 20% rate of return. With a four month delay, the internal rate of return in
an Agile mode of operating is barely affected, while the rate of return on the waterfall
approach falls from around 20% to minus 2%.

Understanding, and crafting the story for, your audience

Obviously, the more you can know about your CFO’s mindset,
the easier it will be to communicate with him or her.

For instance, if your CFO thinks in terms of NPV, IRR or ROI,
you should make sure that you have in hand the numbers that present the case in those
terms. However, in the actual conversation, it will be more important is to present the story that conveys the meaning of those numbers.

If your CFO is more sophisticated and looks to the meaning
behind NPV, IRR or ROI, then the discussion might focus more on overall business
investment risk. Again, stories of firms that did--and those that didn't--manage business investment risk will be key.

If your CFO has mastered the elements of Throughput Accounting, you can start to have a sensible discussion of what really adds value to a firm, through examining the stories of firms that used the approach to drive sensible decision-making throughout the organization.